The allure of diversification …

There is a certain appeal to diversification, particularly when seen as a risk-minimization strategy.

Rick sums this ‘certain something’ up nicely in this recommended twist to how he would set up his own Perpetual Money Machine:

Nothing in life is without risk- but you can minimize risks by diversifying- use multiple types of wealth capacitors some properties, some stocks, even some bonds. You can further diversify with a mixture of commercial and residential properties, properties in different locations, etc.

Similarly you can diversify stocks through buying small cap, large cap, mid cap, and foreign stocks.

If you diversify you can be fairly sure that one bad event doesn’t ruin everything. Of course if the sun goes supernova all bets are off but barring that you should do fine.

And, this is certainly appealing …

… don’t forget that I have been well diversified in almost every area that Rick mentions: multiple businesses; multiple RE investments in different classes (residential; commercial; single condos / houses; multifamily; retail; office; etc.); stocks (but, no mutual funds of any kind … and, I intend to keep it that way!) … but, I don’t recommend it!


I see two problems with this:

1. You spread yourself pretty thinly – you risk becoming a Jack of All Investments But Master of None … this lack of specialized expertise (which you can, of course, try and ‘buy in’) and focus can actually INCREASE your investment risk, hence DECREASE your investment returns, and

2. You automatically consign your returns to the mean/average – not all of your investments can perform as well as your best investment …. if you are comfortable with this ‘best’ investment (or, at least one of your ‘above average’ ones) surely you would put more effort into doing more of those?

The usually arguments FOR diversification then say things like “well, look at the sub-prime and what that’s done to [Investment Class A], therefore you should also do [Investment Class B]” …

… but, they conveniently forget that [Investment Class B] tanked 5 years ago, and will probably tank even worse 5 years hence, whilst [Investment Class A] recovers.

If you diversify you run the risk of averaging your returns down.

In other words, if you can choose your investments wisely your best hedge against risk are a combination of:

a. Time: make sure you can hold the damn thing for 10 to 30 years … if you have a short investment horizon, no amount of diversification will protect you.

b. Higher Returns: if you can hold long enough, every investment worth its salt will recover – and, then some; and, isn’t a ton of cashflow a great ‘insurance’ against risk?

Of course, if you can’t choose your investments wisely, then a ‘regression to the mean’ becomes a GOOD thing … just don’t expect to get rich if you can’t develop any special expertise 🙂

Nope, Rick, my Perpetual Money Machine – which asks me to generate my active income one way (e.g. my job or business), and then create passive income in another way (e.g. stocks or real-estate)  gives me all the diversification that I need!

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0 thoughts on “The allure of diversification …

  1. Hi Adrian,
    Thanks for another great post. On the question of diversification, do you think it has something to do with risk?
    I was thinking about the old phrase of Risk and Return. i.e. the higher the risk the greater the return. This has been used in the past to steer people away from high return. How about taking the opposite view which is; If you can manage the risk better than anyone else then you deserve to get the high return.
    However, there’s only a limited number of risks that you can manage well and this often leads to LESS diversification and sticking to your knitting.
    One of our clients said to me that he knew everything that could go wrong in his business and therefore wanted to pull money out and diversify. My question of him was this: Why would you take money out of something where you know the risk and can manage it and put the money into something different where you don’t understand the risk and therefore can’t manage it!!

  2. I agree Andee, what you commented sounds like the Warren Buffet quote “Risk comes from not knowing what you’re doing.”

  3. Adrian,

    I have to respond to this one even though it’s pretty late – BTW happy Holidays!

    #1 Spreading too thinly- I agree that no one can be an expert in all areas. However, is being an expert worth the effort? I can accept market average returns with virtually no effort: for the sake of argument let us assume for stocks 10% over a 30 year period. Sadly, most professional mutual fund managers don’t beat the market averages, so not only do you need to have special expertise but you need exceptional talent, skill, or luck too! Warren Buffett has a 20% long term record, but he (and a lot of others) works full time to get those returns. Assuming I can develop the special expertise to be as good as Warren I still would need more than $1M of capital for the additional returns to cover the cost of a salary for myself. Unless I’m getting paid by an employer or I have a few million to invest the additional specialization doesn’t pay off!
    I don’t know the numbers for real estate, but it seems likely that a similar argument would hold for any type of market. Most traders (including professionals) would fail to beat the market average although some exceptional traders can do so by exerting full time effort to maintain their skills.
    I suspect that specialization only pays off with an area you have talent and devote most of your time on. The best you can reasonably expect in the long term for any truly passive investment is market average returns. If you have a special talent for picking stocks or real estate, or doing anything else then that probably should be your primary employment. Here is the real problem- how do I know if I have a real talent for trading? To really know you would need to track your returns for years as random selections or a particular strategy can beat the market averages in the short term, but may loses in the long term!

    #2 Chasing returns causes most people to underperform the averages in the stock market. Today’s best investment may well be tomorrow’s disaster. Concentration is risky, if you win great but if you lose you lose big too. I suspect the Enron employees that had all of their retirement savings in company stock don’t have a good feeling about concentration. Diversification reduces risk at the cost of lower returns, but I would argue most people are better off with the lower risk then trying to pick one super stock. I’ve tried to beat the market in the past and I even succeeded for a while, but over the long run I’m no longer convinced that I can reliably do so because of the very convincing arguments in A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing.

    -Rick Francis

  4. @ Rick – Thanks for your comments and Happy Holidays to you, too!

    BTW: I don’t hold ‘special expertise’ in stocks, yet I only suffered a 15% loss in my total US stock holdings, which were 100% financed … doesn’t sound like a great outcome, but the market dropped 45%+ over the same time period and money saved is money earned. In short, we disagree 🙂

  5. Pingback: If you can manage risk, don’t you deserve a better return? « How to Make 7 Million in 7 Years™

  6. Pingback: If you can manage risk, don’t you deserve a better return? « How to Make 7 Million in 7 Years™

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